How Buffett-style investing can protect against the stress of volatility

A 10% market correction is more than enough to cause hysteria in the media. Yet periods of volatility are an inherent part of stockmarket investing. And despite periodic drawdowns, the stockmarket remains a powerful compounding machine that generates wealth over many years.

One of the highest profile proponents of ignoring day-to-day price movements is billionaire US investor, Warren Buffett. He once wrote: "A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful." Implicit in that statement is the idea that periods of mispricing - when the market literally freaks out - are an opportunity for contrarian investors to consider buying quality assets at cheaper prices.

In his most recent letter to shareholders of Berkshire Hathaway, Buffett reflected on why the conglomerate had been so successful over the past 50 years. And he was candid about some of the mistakes he'd made, too. But one of the big takeaways was how he'd made the transition from a "cigar butt" deep value investor to focusing on quality companies that can compound wealth over the long term. His message was that quality really does count.

What is a Buffett-style quality business?

It was Buffett's business partner Charlie Munger who largely influenced his change of approach. While Buffett had made a lot of money with the value strategies taught by his tutor Ben Graham, Munger shaped the the Berkshire blueprint by urging him to "forget what you know about buying fair businesses at wonderful prices; instead, buy wonderful businesses at fair prices."

While Berkshire's success can be credited to numerous factors, Buffett's focus on business and financial quality is a common theme. Typically, these companies have the traits that he would describe as an economic "moat". They're able to protect themselves from competition and market pressures, which means they can command high operating margins and generate high levels of free cash flow, which can be invested or paid out in dividends. Those investments produce strong returns, which can be seen in measures like return on capital employed (ROCE).

With these quality "factors" in mind Stockopedia screened the market for Interactive Investor. It offers a snapshot of the valuation, quality, momentum and dividend yield of some of the market's better quality companies. We also included Stockopedia's broad-based assessment of a firm's quality, called the QualityRank, which scores and ranks all companies in the market according to their financial and business strength - from zero (low) to 100 (high).

Note that all of the companies here have positive six-month relative price strength, which means that their prices have performed better than the market average over the period and through the recent correction.

The list includes some of the most profitable and operationally efficient companies on the market including investment platform Hargreaves Lansdown, fashion retailer Next and satellite broadcaster Sky. Among the midcaps is antibody distributor Abcam, which has the strongest six-month relative price strength, and retail group Dunelm. But even smaller companies can perform well against these rules. Among them is technical supplies company Diploma, online gaming and casino operator 888 Holdings and electronics manufacturer Solid State.

Quality at a price

It's worth remembering that the prices of these types of Buffett-style stocks often become expensive during bull markets. It's in periods like the recent correction that Buffett would be assessing the opportunity to buy quality assets at marked down prices. As always, detailed research is essential. But for an investor looking for the sorts of long-term compounded returns that have been so successful for Buffett, quality factors could be a good place to start.

About Stockopedia

Interactive Investor's Stock Screening series is written by Ben Hobson ofStockopedia.com, the rules-based stockmarket investing website. You canclick here to read Richard Beddard's review of Stockopedia.comand learn more about the site.

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It's worth remembering that these and other investment articles on Interactive Investor are simply for generating ideas and if you are thinking of investing they should only ever be a starting point for your own in-depth research before making a decision.

*No fee for publication is involved between Interactive Investor and Stockopedia for this column.

About the author

Ben Hobson is Investment Strategies Editor at Stockopedia.com. His background is in business analysis and journalism. Ben researches and writes regularly on investment strategy performance and screening ideas for Stockopedia.com. He is the author of several ebooks including "How to Make Money in Value Stocks" and "The Smart Money Playbook".